Recycling Bad Debt into Good Debt with a Home Loan Refinance Strategy

“How can I recycle debt?” you may ask, and what is the difference between “bad debt” and “good debt”? Australian Mortgage Options’ managing director Robert Projeski sheds some light on the topic and explains how we can turn “bad” debt into “good.”

With 15 million credit cards in circulation in Australia as of 2012, consumers all too familiar with debt. But, is it good or bad debt to which we are committing a fair share of our income to every month?

What is the Difference Between Good and Bad Debt?

“Basically, debt that buys assets or produces income is considered ‘good debt,’ while debt that is created by buying life’s niceties or your primary residence is considered ‘bad debt’,” says Projeski. “Not that the debt against your home is normally ‘bad’ debt, since it usually does not bring in any income.”

According to Projeski, many people have a fear of debt and aim at paying their mortgages off as soon as possible, which may not necessarily be the most effective way to use debt. However, using debt to create appreciating assets, rather than depreciating ones that reduce the tax you are paying or effectively earn income, is commonly referred to as “good debt.”

“When consumer confidence diminished it led to less borrowing by consumers, leading to the recent interest rate cuts, making it an ideal time not only to consolidate debt, pooling various loans and credit cards into one loan or mortgage, but to look for ways of making debt work for you,” he says.

Using a Home Loan Refinance Strategy

This is where debt recycling comes in. Projeski provides an illustration:

“Let’s say you own a home in Sydney on which you owe $400,000 mortgage with an offset account attached to it.

“Using the equity in your home, you borrow additional money against it for the deposit, which allows you to buy an investment property. You do this with an interest-only loan. Each month, all the income from the investment property goes into the original offset account attached to the home loan with any tax refunds generated by the investment costs also going into this account."

“The bulk of your wages can also be put to work in this account using your credit card for living expenses, and clearing it at the end of each month. Plus you can seek a tax variation so you pay less income tax every month, rather than annually, leaving even more cash flow to go into this account.

“Money comes out of the offset account to meet the interest payments and other expenses related to the new investment property, but, if you have bought well and done your sums, there should be enough left over for the offset balance to gradually build up, effectively reducing the interest you pay and the capital owing on your primary asset being your owner occupied home,” says Projeski.

Using Good Debt to Further your Investment

“Now once that’s paid off first, there's only tax-deductible ‘good debt’ and the cash flow that's freed up can be applied to either, reduce that debt further or be used for another investment, be it real estate or other.”

In following Projeski illustration, we can start investing earlier than if we waited until the mortgage on our home was paid off and can effectively “recycle” non-productive “bad” debt into tax-reducing and asset creating “good” debt.

It can be complex depending on your individual circumstances and finances and Projeski urges to work closely with an expert - such as an AMO Mortgage Broker - so you don’t end up with more of the “bad” and none of the “good.”